At Deep Sail Capital, we have structured our strategy to take advantage of every identifiable edge that we believe we can reasonably employ. As I described in our fund launch blog post, at Deep Sail Capital we have three primary areas of focus: quality, microcaps, and special situations. In our previous blog post, we already covered why we focus on quality. In this blog post, I will describe what we view as a "microcap" and why it is a focus of our strategy.
We define microcaps in our investing universe as any equity with an enterprise value below $1 billion. Technically, that level probably encompasses some small caps as well, but we have found that companies below $1 billion in enterprise value have historically been good hunting grounds for our investment strategy.
Underfollowed and Unloved
Microcaps are often overlooked by the market due to a lack of awareness or the inability of some investment managers to invest in stocks with such low market capitalizations. Index funds, large institutional investors, and mutual funds are often prevented from investing in microcap stocks either due to a specific investment mandate restriction or liquidity constraints. This creates opportunities for investors willing to do the proper due diligence to buy microcap companies at a discounted valuation compared to their larger peers and their true valuation.
Microcap stocks have limited analyst coverage, which means forecasts of the company's future revenue, earnings, and growth are not in any financial database or company screeners. This lack of data is important as many quantitative strategies might exclude these companies from their investable universe, or investors might become more hesitant to purchase a company without an analyst's insights and consensus forecasts. Investors that are able to do the proper due diligence and gain an understanding of the growth rates, economic model, competitive landscape, and management's plans can take advantage of the lack of knowledge others are not willing to attempt to gain. All of these things lead to lower demand for the shares of these microcap companies and higher variability in outcomes.
Ability to Grow
The idea that scaling from a lower base inherently makes sense to most investors, If a company has $1 million in revenue from 5 sales of its product, it's a lot easier for the company to grow to $10 million from 50 sales of its product than it is to grow from $10 million to $100 million, which would require 500 sales of its product assuming similar unit economics. In general, the smaller the company, the higher its potential ability to grow, but as we have all observed, "potential" and actual growth are two very different things.
At Deep Sail Capital, we spend a significant amount of time trying to understand the end market of the business and determine if the company has the ability to grow the business by multiples of its current size. We are looking for companies that can be 5 or 10 times bigger in the next 5 to 10 years. We want to find businesses that not only have a large current total addressable market ("TAM") but also have the ability to expand their TAM.
Qualitative factors we look at to determine a company's ability to grow:
How do they compare to peers in terms of strategy, product offering, and pricing?
What is the current TAM from the existing product lineup?
How will the current TAM evolve over time?
Are there easy adjacent markets that make sense for them to pursue in the future?
Do they need incremental capital to execute on a growth strategy (i.e., new production facilities, new retail sites, more salespeople, etc.)?
Quantitative factors we look at:
Profit margin trends over time with an emphasis on gross margins
TAM growth over time
Penetration in their current markets
Growth metrics by business or segment looking for inflection points
All large companies start off as small companies. We are looking for small companies that we believe will become much larger over time.
Volatile and Illiquid
Illiquidity causes volatility, and volatility causes opportunity for investors. Microcaps are illiquid by their very nature because they have small market capitalizations and are thinly traded. Generally, microcaps are excluded from most indexes and ETFs, so no passive volume is traded in them on a daily basis. The bid-ask spreads are notoriously wide in microcaps, potentially reaching levels up to 5%. Major news items can have outsized impacts on volume trading on a microcap. Additional positive or negative news items can cause new buy or sell orders that outweigh the orderbook and push the shares of the company either up or down in a wild fashion. This volatility is an opportunity for those investors who have done their due diligence and have the patience to wait for these opportunities to present themselves.
Our criteria for investment in Microcaps
Microcaps need to fit specific criteria for us to be willing to invest. Several books have been written about "multi-bag" (100x returns) stock returns over the years. The original book was "100 to 1 in the Stock Market: A Distinguished Security Analyst Tells How to Make More of Your Investment Opportunities" was published in 1972 by Thomas Phelps. That book was updated by Chris Mayer in 2015 in his book "100 Baggers". The main premise of both books is to look at historical examples of companies that grew their stock prices by over 100 times over the course of the study to determine what traits and attributes those companies had. Through the reading of those books, our own experience, and other subsequent research papers that have been written on the subject, we have developed the following criteria that we look for in microcaps:
1) The company is small enough. The saturation of a company's end market can only go to 100%, and markets generally grow slowly. Companies can only grow by gaining market share, the market size expanding, or entering new markets. Large companies generally have high market shares in their end markets, so they are either forced to compete for a higher market share or they need to enter new markets to grow faster than their market grows. This makes it extremely difficult for large companies to become 100-baggers. We focus on smaller companies that either have a small market share in a large market or are developing products to address new markets. Due to this fact, we look for companies with under $1 billion in enterprise value.
2) The company can reinvest capital at high rates of return. In order to grow the business fast enough to achieve 100-bagger returns, a company needs to have a business model that is able to recycle capital back into the business quickly and efficiently. Highly profitable businesses that have the ability to reinvest their capital at higher rates than the cost of that capital create real economic value. As businesses grow their revenue and profits, they grow their terminal value, or, put another way, they compound their terminal value. Combining high growth with high returns on capital (ROC) can yield incredible long-term value creation. We look for businesses that can not only grow fast but also have a model in which reinvestment of their capital has proven pathways to success.
3) The company's products have a large addressable market. We look for companies that either have a large addressable market as compared to their current market share or are in a burgeoning market that is set to expand significantly. Markets that are early in development (like cell and gene therapy) are more attractive than stable markets, as the market size is set to expand in the future along with the company. Early markets also offer a less competitive marketplace as incumbents are already in place. We would like to find the new incumbents in these early markets that will take the majority share of these new, growing markets.
4) The company is led by a strong and honest management team. Strong and honest management is the one factor that we do not view on a scale, but rather as a check box. Companies either have strong and honest management teams or they don't; there is no in-between. We will not invest in any company that does not pass our assessment of their strength and honesty.
To assess management teams, we look at the following:
Have they done what they said they would? Did they execute on their previous plans?
Have they pivoted from their strategy before? How often do they pivot their strategy? Many pivots show they don't have a long-term vision or the drive to execute it.
How do they treat their own equity? Are they constant share issuers, and are insiders constant sellers of shares? We want management that is an owner and treats the company's shares as valuable.
Are they always upfront and honest when issues arise?
Are they highly promotional? Highly promotional management teams are a red flag.
The Historical Results
Over long periods of time, microcaps outperform. The Fama-French model devised one of their initial factors to account for this market persistence, called SMB, or Small minus Big. This market factor was identified in the early 1980s and has been adopted into several investment strategies since then that try to exploit it. Thus, some have argued that this factor has diminished over that period. We believe the core reason for Microcap's outperformance, which we highlighted in the above section, remains largely intact. Those that layer on proper due diligence and industry focus in the microcap equity universe will still outperform equity managers that invest solely in the large-cap equity universe with similar efforts. That is why we choose to spend our time and capital investing in microcap stocks.
Sean
Manager - Deep Sail Capital